‘Alternative finance’ is an internet-era rival to traditional banks. There are opportunities for smart investors, says David C Stevenson.
The financial crisis of 2008 was good news for one area of the finance industry – ‘alternative finance’. This catch-all term covers activities such as ‘peer-to-peer (P2P) lending’ and ‘crowdfunding’ – in short, companies that enable individuals and firms to raise money while cutting out banks. While companies such as P2P pioneer Zopa already existed, widespread disenchantment with traditional banks, and the low interest rates on offer, brought a surge of interest in Zopa and rivals such as RateSetter and Funding Circle, who promised to use the internet to establish marketplaces where savers looking for a higher return on their money could lend it to borrowers looking for a better rate than banks were offering. Even the government could get behind this vision – the Treasury has consistently helped the sector along, especially platforms that target the small business (SME) sector, such as Funding Circle.
It’s all very exciting. And I for one think any serious investor or saver should pay attention to the rise of P2P finance. But there are a few things to get clear before you go bounding in. Firstly, despite all the press coverage, the sector is still very small. By my reckoning the total transaction flow of the top five platforms (Zopa, Ratesetter and Funding Circle within P2P, and MarketInvoice and Platform Black in invoice funding for SMEs – which we’ll get onto shortly) to date amounts to not much more than £650m. That’s tiny compared not only to the big high-street banks, but also to the impact of ‘new’ banks, such as Handelsbanken (consistently voted the best consumer service bank in the UK) and upstart Metro Bank. If small businesses are looking for ‘alternative’ sources of finance they are still more likely to approach these “new banks”, or specialist asset finance businesses that already exist. ‘Alternative finance’ providers such as Funding Circle, ThinCats and FundingKnight are a minority choice, for now at least.
Secondly, while they are often pitched as alternatives to banks, these are definitely not banks we’re dealing with. The likes of Zopa and RateSetter offer better rates of return than their high-street peers. But there is a reason for this – they are not deposit-taking institutions. There is no backing by the Financial Services Compensation Scheme, as with high-street banks. These are online exchanges that allow you to borrow from, or lend money to, other individuals, but they do not guarantee your money.
So when RateSetter, for instance, advertises a five-year return of 5.5% for its savers, it might be attractive, but it’s not risk-free: as the lender, you will have to shoulder the burden of any losses (‘defaults’) out of this income. Currently RateSetter and Zopa boast remarkably low default levels of between 0.28% and 0.34% on average, but that could rise substantially if there is a recession and insolvencies shoot up. If defaults soar, you, the saver, could take a hit. That said, both Zopa and RateSetter have established well-funded protection schemes financed out of income, which would almost certainly offer substantial respite from any wave of defaults.
With those caveats out of the way, I’d like to emphasise that this sector has huge potential. In America, for example, where they’ve taken a great British financial innovation and ran with it, the two big P2P platforms, Lending Club and Prosper, now have well over $3.2bn in cumulative deal flows between them. And next year could prove a watershed for the British alternative finance sector. In the spring it will become regulated by the Financial Conduct Authority (FCA), bringing it firmly into the mainstream. And big institutions have realised that P2P is big news. For example, Liberum Capital’s Exchange Associates vehicle is looking to raise £200m to invest via P2P platforms in both the US and the UK, meaning we can expect a rush of money into the sector. So who are the big players, and how can you take advantage?
The main types of alternative finance
Alternative finance companies have a few things in common. They are all internet-based. They tend to be very social, with the crowd playing a major role in setting both the price (interest rate) for capital, and its supply. In terms of relationships, the provider (or platform) is just there to facilitate the exchange of capital. In other words, you have a contractual relationship with each customer or borrower, as well as the platform. So in theory, if the platform goes bust, your loan to an individual or business need not necessarily be affected.
There are three main areas in the sector to be aware of, and new companies are sprouting up all the time. By far the biggest opportunity in the sector right now is in the P2P lending area. This was pioneered by Zopa, but now includes names from RateSetter and Funding Circle through to ThinCats, RebuildingSociety, Assetz and FundingKnight. These firms provide a route for people with savings to lend that money to individuals or businesses looking for loans.
Then there’s the world of ‘crowdfunding’. This involves investors buying equity in young businesses – it’s almost like a private online stock exchange. Companies include Crowdcube, Seedrs, Abundance and Kickstarter. Finally, there’s the fast-growing world of online invoice funding. This is where investors advance money to companies who are owed money via their invoices. Sample companies include MarketInvoice, Platform Black and AztecExchange. You can read more about all of these companies below.
Starting out with P2P
Most savers will probably start with the biggest P2P platforms – Zopa, RateSetter, and Funding Circle. The following table gives a very simplified summary of the returns on offer from the largest – these rates (net of fees) were advertised as of the third week of September 2013 and are likely to change on a regular basis.
Zopa: 3-year: 4.2%. 5-year: 4.7%
Funding Circle: 5.8% (average net return).
RateSetter: Monthly: 1.7% 1-year: 3%
3-year: 4.1% 5-year: 5.5%
Zopa currently boasts the most money lent via its platform (over £350m), but RateSetter is catching up fast (currently on £110m), helped in part by its wider range of savings products (it offers monthly and one-year options as well as the core three and five-year terms). Both Zopa and RateSetter have built a business model around online platforms that allow savers to lend to borrowers (via small investments that start at £10 a go), across different risk categories and different time periods. The platforms take a cut of each transaction.
These are far from being just ‘dumb’ platforms where you are left with all the risk of batting off borrowers who will never repay you. Both Zopa and RateSetter have developed remarkably robust credit scoring and analysis systems. In fact, at a recent conference for City investors, Zopa’s chief executive, Giles Andrews, observed that a consulting firm had asked if it could white-label its credit system to a major conventional financial institution.
Whether these credit analysis systems (which focus on looking for customers who won’t default) will stand the test of a recession is another thing. Zopa, for instance, did see a noticeable uptick in defaults in the last quarter of 2008 as the last recession kicked in. But to be fair, this upsurge didn’t even push its default rate past 1%. Also both platforms go out of their way to focus on the most credit-worthy borrowers possible – ‘super prime’ or ‘prime’ borrowers.
Lending to businesses
Funding Circle is perhaps the most revolutionary of the three major platforms, as it focuses on small or medium-sized enterprises (SMEs). This is intrinsically riskier – most of its clients are incorporated businesses, which in theory means the directors could just walk away from their debts. But in practice, Funding Circle is on to its third generation of credit analysis technology and goes to remarkable lengths to incorporate every scrap of data publicly (and privately) available to check the ‘robustness’ of a business borrower. If that doesn’t do the trick, its frequent use of personal directors’ guarantees should assist – it requires directors to offer up their homes as a guarantee if necessary.
Even so, it’s hard to believe that Funding Circle could ever hope to match the low level of defaults enjoyed by its consumer peers – currently its default level is running at around 1.5%, but it’s entirely possible that that loss rate could treble if not quadruple during a severe recession. For example, corporate bond default rates in the US business market have risen as high as 10% a year in a severe recession.
So what happens if a borrower does default? Funding Circle (unlike Zopa and RateSetter) does not have a protection fund, but it has expanded its debt recovery service, which might help in getting some of that money back. Ultimately though, investors could suffer losses, which – take note – you can’t deduct against any income tax payable. For now, any losses from defaults on a P2P platform cannot be used to offset income (though I suspect this will change next year).
Given this higher potential for losses from lending to volatile businesses, its little surprise that Funding Circle tends to quote a higher net (after potential defaults and costs) return of around 5.8% a year, although that will vary based on the length of time you lend for and the perceived ‘risk’ of the borrower. Lend to a “riskier” business rated a C (as opposed to a top-notch A) for over five years, and your gross return could easily be in the double digits, but clearly you also have a higher risk of default.
What to watch out for
Given the low levels of defaults, it’s easy to understand why many investors are tempted, especially compared to other mainstream income options. For example, most new issues of London Stock Exchange-listed retail corporate bonds rarely boast yields of much more than 5%-5.5% for a six-year term, whereas RateSetter offers 5.5% (before any potential defaults) for five years. And P2P investors don’t just have to buy one bond from one company – they can diversify across hundreds of borrowers. The big platforms also allow investors to sell loans early via secondary markets.
All the same, before you invest, it’s worth applying the same standards to P2P lending as you would to a conventional fixed-income security – such as a gilt or a corporate bond. To do that, we have to look at the concept of ‘spreads’. This is the difference in interest rates on offer over different periods of time (duration, or ‘term spread’) and different risk levels (‘risk spread’). All things being equal, the riskier the investment, and the longer the term, the higher the rate of return. As an investor, you have to ask yourself, is the term or risk spread wide enough to reward you for future uncertainty?
For example, looking at those rates mentioned above, lending for five years on Zopa rather than three gives you an extra 0.5% a year. For RateSetter, the ‘spread’ for three to five years is roughly 1.5%. By contrast, lend to the British government – which has never defaulted, to date – and the extra yield moving from three to five years is just under 1%. And if we look at a popular corporate bond issued by, say, BT, the equivalent term spread rises to 1.3%, and in some cases it can top 2% for other reasonably safe UK corporate bonds.
So a P2P investor has to consider whether that extra 0.5%, for example, is worth the risk of lending for an extra two years – particularly given that default rates could soar in any future recession (so the longer you hold it, the riskier it is). To get an idea of how high defaults could go, consider that US data, from credit rating agency Standard & Poor’s and credit-rating firm Experian, suggests that defaults across all consumer loans (including mortgages) stand at 1.35% a year just now. But in the middle of the recession, in spring 2009, that rose to 5.5%. So a severe recession could hit P2P lenders hard. Savers should also consider the consequences of a general rise in interest rates – there’s better returns on offer from banks, while rising rates would put pressure on all borrowers.
But on balance, I would definitely recommend the major P2P platforms. You can’t yet invest via a self-invested personal pension (Sipp), unfortunately, but I’d wager that will change in 2014, as the Treasury tries to build up the alternative finance sector. I’m particularly keen on the shorter-term loans – around one to three years. That’s because I don’t expect a severe recession during that time period, so at current yields you are probably being amply rewarded for taking on default risk.
For the more adventurous
If you’re a wealthier investor, with more of an appetite for risk, you might want to investigate the smaller, more exotic platforms. As the bigger P2P platforms have become more popular, some of the more experienced P2P investors have moved beyond the most liquid exchanges towards their smaller, auction-based rivals, which can sometimes throw up real opportunities.
ThinCats is perhaps the biggest rival to Funding Circle. It has a very different model: borrowers partner up with existing specialist finance brokers to ‘list’ their loan requirements to a syndicate of investors. I think you could get a net return of at least 7% (after defaults and charges) for a five-year term on this fast-growing platform. You might manage even higher returns from smaller rivals, such as FundingKnight (which has recently received funding from a savvy institutional investor) and Rebuilding Society. You can read more about these platforms in the column on the right.
Others have moved out of P2P lending altogether, and are instead lending to smaller businesses against their flow of invoices. Essentially, you are helping small companies to manage their cash flow. Platform Black (www.platformblack.com) boasts many experienced high net-worth investors, and it’s growing fast, with new business hitting £5m a month, although rival MarketInvoice (www.marketinvoice.com) – which is only open to institutional money – has a much bigger footprint of deals, with £65m in total business to date.
Annualised rates of return on these platforms – where you lend against SME invoices to big clients with typical duration of 30 to 60 days – can come in at between 10% and 15%. Duration risk is low (these are short-term invoices) and default levels are too (for now), but you will have to analyse carefully the risks involved in each deal. If you are looking to lend via Platform Black, you’ll realistically need to be investing a few thousand pounds at least, and remember that this should be part of a diversified portfolio, not a ‘bet the house’ shot.
Finally, there’s equity crowdfunding. As mentioned, this is basically like a private version of the Alternative Investment Market (Aim) – you buy shares in young companies, which is traditionally the preserve of experienced ‘angel’ investors. The risk of failure and total capital loss is much higher than with P2P lending – most experts suggest a rough rule in which nine out of ten start ups don’t return their investment, although a more forgiving recent analysis for a business angels network suggests that the failure rate on a diversified portfolio could be closer to 60%. But the hope is that those losses will be dwarfed by the one or two companies in a portfolio of a dozen that turn into tomorrow’s Facebook or ARM.
The major P2P platforms
Getting started in the world of crowd funding and P2P lending is relatively simple. The first thing you need to do as an investor is create an account with the specific site that you want to lend with. While there may be a few restrictions (for instance, Zopa requires that you are not already involved in commercial lending), the main requirements are that you are over 18 and in possession of a British bank account. Once this is completed you simply put money into your account, and you can start lending.
Zopa (www.zopa.com): the first, and still by far the biggest, consumer-focused P2P lending platform. Boasts the most savers and the most liquid secondary market if you want to sell loans.
RateSetter (www.ratesetter.com): a challenger to Zopa in the P2P consumer sector, with a fast-growing book of business and a wider range of products, including monthly and one-year terms for savers. It also introduced the first protection fund, which was then copied by Zopa.
Funding Circle (www.fundingcircle.com): this is another verysuccessful P2P platform, but this time focused on lending to SMEs. Over the last couple of years it has grown rapidly, helped by government support. Rates are higher because lending to SMEs is riskier: the average net yield is 5.8%, but this can near double digits for riskier loans. You can start with a minimum of just £20. The SMEs, which come from a wide range of industries and in a range of sizes (and include sole traders and partnerships as well as limited firms), indicate the amount of money that they need, the interest rate they are willing to offer and the duration. Extra information, such as the firm’s credit rating and the loan’s purposes, is also displayed. You are then given a set amount of time to bid for parts of the loan.
If you have limited time for research, you can choose an autobid function, which allows you to select the interest rate that you are seeking. The computer then seeks out loans with those rates and spreads your investment out over them. Another interesting feature is the ability to buy and sell loans that are already in progress on a secondary market. Funding Circle charges investors a 1% fee on all loans and a 0.25% for selling loan parts to other investors.
Tips for the major P2P platforms
Diversify: have a good spread of individual investments and look at diversifying between platforms and even sectors ie, have some business and some consumer loans. For platforms such as Zopa, you should aim to have a portfolio of anything between 25 and 200 loans (we’re talking £250 to £2,000 here). Invest slowly and aim never to put more than 1% or 2% of your capital in one loan.
Keep reinvesting: remember the headline rate – say 9% – is only what you get on the outstanding amount, but that number falls with each repayment. Actually to get your 9%, you need to re-invest your money as it is repaid.
Paying higher-rate income tax? Tax could be ruinous for those paying higher-rate income tax as defaults on riskier investments can’t be offset, but they still have to pay 40% marginal rates on the gross (before default) income.
Risk: investing in riskier loans can make sense if the economy is strong and defaults low. But as one active investor I spoke to put it, “If losing £20 worries you, don’t invest anything”.
Platforms for adventurous investors
ThinCats (www.thincats.com): a fast-growing rival to Funding Circle. Focused on targeting sophisticated, wealthier investors with an auction-based platform. The site aims to broker relatively large loans – between £50,000 and £3m – over periods of six months to five years, and borrowers have to provide security. The minimum investment is £1,000. Net returns of between 7% and 10% a year are possible, but clearly it’s risky.
FundingKnight (www.fundingknight.com): another rival to Funding Circle, offering loans to small businesses. It’s very much aimed at the man in the street – you can invest from as little as £25. Prospective investors bid in an online auction to participate in a loan – there’s plenty of information about the borrowers on the website, so investors can decide which look the safest. Those bidders offering the lowest interest rates win a stake in the loan. Rates for lenders are typically between 9% and 12%.
RebuildingSociety (www.rebuildingsociety.com): maverick lender to SMEs, with very strong ideas around being as social as possible with its savers. Suggests that returns could be into double digits.
Crowdcube (www.crowdcube.com): along with Seedrs, invented the crowd funding equity investment space. Has attracted some high-profile projects, including Nicola Horlick’s latest venture.
Seedrs (www.seedrs.com): another crowdfunding platform and rival to Crowdcube. Sought FCA approval from the very beginning.
Relendex (www.relendex.com): a revolutionary new platform that allows experienced investors to back commercial property projects. This niche has huge potential, but it’s still very early in terms of deal flow. Secure assets with a range of returns between 5% and 7.5% per year.